What it means
Some securities are issued with a built-in right to switch into something else. A convertible bond, for example, pays interest like a normal bond but lets the holder trade it in for a fixed number of ordinary shares at any point before maturity.
For the company, the attraction is a lower interest rate, because investors will accept less income in exchange for a share in the upside. For the investor, conversion is the moment a lender's position turns into an owner's position, which only makes sense once the shares are worth more than the bond.
Mechanically, conversion starts with the holder sending a notice to the trustee or transfer agent, who cancels the old security and issues the new shares. The number of shares is set by the conversion ratio, which is fixed at issue and adjusted for share splits, bonus issues and unusually large dividends.
Converting early is rarely sensible if the bond pays more income than the equivalent shares would in dividends, because the holder gives up both the coupons and the downside protection of ranking above shareholders. Issuers therefore often include a call feature that lets them force conversion once the share price sits comfortably above the conversion price for a sustained period.
From the company's side, conversion removes debt from the balance sheet and adds equity, which improves gearing but dilutes the existing shareholders. Diluted earnings per share usually already assumes conversion has happened, so the accounting effect is signalled well before the event itself.
In practice
Real-world examples.
Example
A logistics business issues convertible bonds to fund a depot network at a coupon of 3% instead of the 7% it would pay on ordinary debt. Three years later the share price has doubled, holders convert, and the company retires the entire bond issue without paying a cent of principal.
Example
A family-owned engineering firm brings in an outside investor through preference shares that convert into ordinary shares if the firm ever lists. The listing goes ahead, conversion is triggered automatically, and the investor moves from a fixed dividend to a full ownership stake.
Example
An early backer of a medical devices start-up holds a convertible note. When the company raises a priced funding round, the note converts into shares at a set discount to the round price, so the backer ends up with more shares per dollar than the new investors.
Formula
Calculation
Shares received on conversion = Face value of the security / Conversion price. The result is also known as the conversion ratio.
An investor holds 20 convertible bonds issued by a software company, each with a face value of $1,000, so the total face value is 20 x $1,000 = $20,000. The conversion price written into the bond is $25 per share.
Shares per bond = $1,000 / $25 = 40 shares. Total shares on conversion = 20 x 40 = 800 shares.
The company's shares are now trading at $34. Converting produces stock worth 800 x $34 = $27,200, against a face value of $20,000. The gain from converting rather than holding to redemption at par is $27,200 - $20,000 = $7,200, before allowing for the coupons the investor gives up by converting early.Case study
Seen in the real world.
This is an illustrative, fictional scenario. Halcyon Diagnostics, an invented laboratory equipment maker, raised $30,000,000 through convertible bonds at a 2% coupon when its shares were trading at $18, setting the conversion price at $24. The finance team liked the low cash interest cost and assumed most holders would simply take their money back at maturity.
Two strong product launches later the shares were trading above $40, and holders began converting in blocks. Halcyon's debt fell sharply, its gearing improved, and the finance director was pleased until the board asked why the share count had risen by almost a fifth. Nobody outside the treasury team had modelled what full conversion would do to earnings per share or to the founding family's voting position.
Halcyon now runs a standing conversion schedule alongside its debt maturity profile, showing how many shares would be created at different share prices. The lesson from this fictional case is that conversion is a certainty to be planned for, not a surprise to be managed after the fact.
Watch out
Common mistakes.
- Thinking conversion brings new cash into the business. It does not; the money arrived when the convertible was first issued, and conversion only swaps one claim on the company for another.
- Assuming holders will always convert as soon as the shares exceed the conversion price. Many hold on for the coupon income and the protection of ranking ahead of shareholders, converting only when forced or close to maturity.
- Ignoring conversion when forecasting earnings per share. The diluted figure already assumes the shares exist, so a forecast built only on basic earnings per share will overstate what shareholders actually get.
Questions
People also ask.
Who decides when conversion happens?
Normally the holder, within the window set out in the terms, although a call provision can let the issuer force the decision once the share price clears an agreed level.
Does conversion create a taxable event?
In many jurisdictions a straightforward conversion is not treated as a disposal, but the rules vary, so the position should be confirmed with a tax adviser before acting.
What happens to accrued interest at conversion?
It depends on the terms; some issues pay accrued interest up to the conversion date, while others treat the surrendered coupon as part of the price of getting the shares.
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